BHP Billiton
has delivered on
Andrew Mackenzie
’s introductory commitment that definitive capital prudence and discreet cost management would generate differentiating outperformance, with the company delivering an interim profit that has crushed market consensus.

On his appointment in February last year Mackenzie promised that a “laser-like focus" on operational and capital efficiency would produce productivity gains that would, in turn, manufacture a very real and sustaining impact on the Global Australian’s cash generation and profitability.

He has proved true to his word.

At $US7.7 billion ($8.5 billion), BHP’s interim profit came in just shy of $US1 billion ahead of equity market consensus and just more than 30 per cent ahead of the impairment-affected FY13 interim. Underlying EBIT rose by 15 per cent to $US12.3 billion, cash flow jumped 65 per cent to $11 billion and net debt is forecast to hit $US25 billion by the end of the financial year.

That is an important milestone in these early days of the Mackenzie era because it is target that BHP has previously indicated would trigger capital management that is expected to take the form of a buyback.

The important thing to appreciate here is that this broad strengthening in BHP’s bottom lines is essentially the product of things that management controls.

“This result is driven by our own self-held [belief] and our own productivity," Mackenzie asserted on Tuesday, adding: “We certainly don’t feel that we are finished with our productivity gains."

Entering the third phase

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The first was a spike in China’s steel production that so profoundly overreached the miners’ capacity to supply that raw materials prices rocketed to unprecedented levels and dragged a basket of other commodities prices along with them.

The second was a capital boom that saw the whole resources sector respond to price signals by funding massive capacity expansion that both followed demand (iron ore and coking coal) and anticipated it (liquefied natural gas).

And this third wave has started with the end of a capital boom that arguably cost just about every senior CEO in the mining game their jobs and a disciplined, sustained drive maximised returns from capacity new and old.

As this investment cycle matures it will be this constant fine-tuning and cost management that feeds the miner’s profit growth. And we should expect that a goodly portion of the massive pools of excess cash this fiscal rectitude will most certainly create will be handed back to shareholders.

For example, while iron ore prices remained strong through the half, falling commodities prices across the balance of BHP’s portfolio stripped an estimated $US700 million from EBIT with underlying inflation across the business stripping out another $US300 million. Now, just on iron ore pricing, to digress for a moment, it will be exceptionally interesting to watch how the wider market digests what is a subtle but important change in BHP’s narrative on iron ore markets.

Mackenzie echoed the broader industry view that Chinese growth is slowing. But he added to that mix the idea that within maybe two quarters, iron ore production will be running at a faster pace that demand.

BHP, of course, has been talking “mean reversion" in pricing for some time. But Mackenzie’s pitch is not clouded by marketing jargon. While he has certain confidence in the long demand story built on informed forecasts that Chinese steel output will hit 1 billion tonnes sometime after 2025, he thinks prices will flatten as calendar 2014 closes and that they will become substantially less volatile as surplus capacity slips into the market.

What a difference the dollar makes

Now, the fiscal corollary of the price cycling evident in BHP’s numbers was a long-awaited recovery of the US dollar across the suite of BHP’s currencies, the most critically being the Australian dollar. Through its December half, exchange rate fluctuation added back $US1.5 billion to BHP’s EBIT.

But it was the things that BHP controlled that made the real difference. A range of cost initiatives – some of long-standing, many new – extracted $US1 billion from its controllable costs. To that Mackenzie’s team added $US500 million in the form of “productivity volumes" from existing capacity and then $US700 million from newly installed capacity. After all this give and take on BHP’s waterfall of financial life, the end result is that operating costs fell 2 per cent to $US17.4 billion while production in copper-equivalent terms rose by 9 per cent.

So while revenue was essentially flat at $US63 billion for the half, the company was able to throw off an extra $US7 billion in cash flow and confirm increases across all of its headline profit metrics.

Over just shy of two years, BHP has extracted $US4.9 billion in what it classifies as productivity gains and Mackenzie says that number will hit $US5.5 billion by financial year end.

Identifying FY12 as the baseline for valuation of his newly productive BHP is important.

It announces that BHP was probably two years ahead of the curve in its systematic drive on costs and plainly acknowledges the contribution of management teams past to what might otherwise look a very sudden righting of this massive ship.

The other side of this balance sheet is that Mackenzie’s BHP is simply going to spend a whole lot less on itself.

Capital and exploration spending will fall by 25 per cent over FY14 to $US16.1 billion and beyond that Mackenzie has said he can expect that to fall further, and be sustained at around $US15 billion or so.

Exploration loses out

The big loser from all of that will be the company’s explorers. BHP will spend $1.4 billion less on exploration this year as Mackenzie forces his teams to orbit resolutely around BHP’s four geographic and product pillars (Pilbara iron ore, Chilean copper, US conventional and unconventional petroleum and Queensland coal).

Mackenzie’s logic here is that BHP just does not need to invest in the discovery and assessment of prospects distant from his hubs because they will bring no potential to influence the company’s earnings for “40 years or more". This hard line on exploration informs an approach to capital allocation that is now shared by pretty much every other leader in the mining business.

How long it will be sustainable, well, time will tell, I suppose.

But Mackenzie’s command of five or six of the worlds biggest minerals and energy basins leaves him possibly best-placed among his competitors to justify the idea that the retreat from exploration will not constrain growth over the longer term.

Right now, though, growth is more than locked in.

BHP affirmed guidance that production would increase by 16 per cent by the end of FY15. And there is a further $US17 billion of project development that will underpin volume growth well beyond 2017.

Interestingly, it is at the bottom end of BHP’s food chain that Mackenzie’s productivity push is having its most observable effect. The aluminium silo was expected to lose maybe $US50 million.

It made $US77 million. Nickel’s losses were expected to top $US250 million. The division lost $US150 million.

The Queensland coal business offers a perfect study of Mackenzie’s newly disciplined BHP. The biggest metcoal miner in the world ran at record production levels through the half and unit costs fell by 25 per cent as new mines ramped up and tired ones disappeared. And in the end underlying EBIT came in at $US372 million, slightly ahead of expectation dampened by 10 per cent fall in the average hard coking coal price.

But that represented a 7 per cent return on capital against a BHP-wide average of 22 per cent. Which means only that metcoal will not get any new investment until it is improves itself further.

So, the picture here is a business that is driving profitability through demonstrable productivity gains across its operational portfolio, that has contained its capital commitments through disciplines that will embed higher investment hurdles through internal competition for funding and has a growth outlook substantial enough to likely mitigate downside price volatility.

The product of all that is BHP will increasingly throw off excess cash flow, the board will exercise some form of capital management through FY15 and, beyond that, a recovered balance sheet flexibility will see capital returns of one form or another become as routine as they have been in the past.